Making money from dividend-paying stocks is one of the basics of good investing. But you need to know what dividends are and how they work if you want to put them to good use. Learn how these kinds of stocks add a stream of income to your accounts.
What Is a Dividend?
A companies funds dividend payments when it earns a profit. It uses part of these profits to send money to the people who invested in them. The board of directors meets to listen to company leaders, who suggest how much of the profit should be set aside for growth. A portion of what’s left is then paid out to shareholders as dividends.
Why Use Dividends for Income?
Your dividends can be reinvested. You can also use them to pay household bills, to send a child to college, to start a business, pay for vacations, or give to charity. The more shares you own of good dividend stocks, the more money you can make. Dividend investors collect this specific type of investment over time. Your net worth and income will keep growing as time goes on if you invest well.
An Example of Dividend Investing
Suppose Anthony is 18 years old and he’s just gotten a job. He decides that he wants to start making money from stocks, so he begins to invest. He chooses shares of big blue chip firms. He looks for ones that show healthy growth, strong balance sheets, and a solid history of raising the dividends it pays out over time. He wants to avoid taxes, so he opens a Roth IRA to hold these stocks. Anthony can add up to $6,000 to this account each year because he’s younger than age 50 and that’s the limit set by the IRS as of 2022. This move gives him a great edge in tax planning because he’ll never pay a penny in taxes on the gains he makes in this account as long as he follows Roth IRA rules. Contributions are made with after-tax dollars and they can’t be deducted from income, so any money he takes out will be tax-free after five years. Anthony is able to grow his money at 8% for the next 50 years. Thanks to compound interest, his portfolio grows to more than $3 million by the time he reaches 68 years old and decides to retire. He could collect about $96,000 in dividends each year if he invested wisely and picked stocks with an average dividend yield of at least 3%. That’s cash in his pocket. And he doesn’t have to pay any taxes on this income because he holds the stocks within his Roth IRA account.
Important Things to Consider
Making money from dividend stocks involves a handful of key factors:
The dividend yield that a stock offers at the time you buy it The rate of growth in the company’s profit, which can be used to project future dividend increases The health of the company’s balance sheet Current dividend tax laws
The net investment income tax went into effect in 2013. This tax collects 3.8% from your net earnings, depending on how much you earn and your filing status. It applies to those who make more than $200,000 a year and who are filing single or head of household, or more than $250,000 a year if married filing jointly (if married, filing separately, the income threshold is $125,000). That could affect your bottom line if the threshold applies. Picking a firm with tons of debt and falling sales is always a big risk, no matter how large the payout may appear. You might instead look at a low-cost index fund that’s focused on dividend-paying companies. An index fund is an exchange-traded fund (ETF) or mutual fund that tracks a certain market index. You don’t have to select each stock on your own with this option, but you can still try making money with dividend investing. You can also take a look at dividend-focused ETFs, such as the iShares Select Dividend ETF or the Vanguard Dividend Appreciation ETF. Be sure to read the mutual fund prospectus before you invest. This tells you how the stocks held in the fund are chosen. It will help you decide whether the risks are right for your situation.
